Diversified investment companies, in general, are based on the concept of pooling resources from many investors and benefitting from the expertise of the fund's managers who use their experience to invest the pooled resources to earn financial gains for the investors.
A basic concept of all such funds is the Net Asset Value (NAV) of the fund. The NAV is based on the ratio of a fund's net assets to the number of fund shares outstanding. (i.e., NAV=Net Assets/Shares Outstanding). Changes in the NAV of a fund is a direct measure of a fund's investment performance.
There are generally two broad categories of investment companies: open end (mutual funds) and closed end funds. Investors in open end funds purchase shares of the fund directly from the fund, at a price equal to the NAV of the fund. Investors in closed end funds, on the other hand, purchase shares of the fund on an equity exchange, such as the New York Stock Exchange (NYSE) at the market price (MP) of the fund. Shares of closed end funds are traded on equity exchanges in much the same way as are other equities.
Closed end funds rarely trade at their NAVs but, rather, almost always trade at a discount (or a premium) which is created based on supply and demand. A discount results when the supply of fund shares is greater than the demand by investors, and thus, sellers of the fund shares are forced to accept a lower price for the fund than the NAV. A premium, conversely, results when the demand is higher than the supply and investors are forced to pay a higher price for a limited supply.
There are at least two independent factors that can affect the price per share, and the discount (or premium), of a closed end fund: (1) supply and demand for the fund shares, and (2) the NAV of the fund. Because these two factors act independently, historically, there has been a lack of correlation between the MP of most closed end funds' shares and the respective fund's NAV per share. This lack of correlation in closed end funds is inconsistent with the most sought after benefits of mutual funds, such as portfolio diversification, stated investment objectives, professional management, and investment performance. For instance, an investor who chose to invest in a closed end fund because of its stated objective of capital preservation is, because of the poor correlation between MP and NAV, exposed to the effects of supply and demand on the fund shares which can potentially place the investor's investment at considerable risk.
For example, an investor purchases 1,000 shares of a closed end fund at $25.50 per share at a time when the fund's NAV is $30.00 per share. The discount is 15%, calculated as: ##EQU1## The total investment for this purchase is $25,500 ($25.50 per share.times.1000 shares). Assume that the investor wants to sell all 1000 shares at some later date on which the price per share is $27.00 and the NAV is $36.00. The discount on this date is 25%, calculated as: ##EQU2## By selling 1000 shares on this date at $27.00, investor earns a gross profit of $1,500 ($27,000-$25,500), which is an increase of 5.88% on the initial investment calculated as: ##EQU3## Over the same time period, however, the NAV has increased by $6.00 or 20%. If the discount had remained at 15%, the increase of the NAV to $36.00 would have resulted in a price per share of $30.60, calculated as: EQU $36.00-($36.00*0.15)=$30.60
If the investor had sold all 1000 shares at this price, the investor would have earned a gross profit of $5,100 ($30,600-$25,500).
Clearly, because the discount increased from 15% to 25%, the investor earned only $1,500 and lost the potential to earn an additional $3,600. Had the investor been protected against the increase in the discount, the investor would have been able to benefit fully from the increase in the NAV. This did not happen, however, because of the lack of correlation in closed end funds between the MP and the NAV, which is due to market forces acting on the fund shares.
This example illustrates a problem inherent in closed end funds, i.e., the exposure of the fund shares to market risk can cause the discount to increase and thereby preclude an investor from fully benefitting from the true performance of the fund as the performance is measured by the NAV.
The present invention addresses this problem by implementing a method and system for supporting a new financial instrument that protects an investor from increases in the discount of a closed end fund over a specified time period.